An OID also known as original issue discount is a debt instrument with a lower value compared to the time it was bought. The investor receives the face value after maturity with interest paid by the issuer or borrower. While the bond yields no interest to the owner until maturity, the IRS places income tax on the discounted price of the bond. The mandate is because the price discount is considered additional income to the bondholder. In essence, OID is a zero-coupon bond with tax payments based on its predicted payouts considered as income.
The value of the bond is the payable amount by the issuer to the bondholder at maturity. However, bond issuers hardly sell bonds according to their face value. Thus you can buy a bond less and make more at the time of maturity. The OID is the interest the bondholder makes at the very end. In essence, the bondholder makes an interest during the growth and another at maturity. However, some bonds, like zero coupon bonds, only attract the OID on the bond at maturity.
A transaction is considered an original issue discount when a bond is worth less than its initial purchase price. The OID is what is left after the discount price and redemption price. Many discounts happen at 1 percent or 2 percent. Also, many people add the OID as a strategy to attract a buyer since the buyer gets the bond at a lower price and redeems it at a higher price.
Original Issue Discount (OID) is the Redemption Price minus the Issuance Price
The redemption price is the face value of the bonds
While the issuance price is the buying value of the bonds
For example
Pat Olivia Inc. is raising $100,000 as the debt; they may decide to attract investors by offering the bond at a cut down value of $98,000. However, the investor stands to gain a par value of $100,000 or more as interest which is calculated compared to the interest rate.
Borrower’s Perspective: since the bond will be sold at $98,000, the borrower will make $980 for each penny.
Bondholder’s Perspective: the investor purchases the debt at $98,000 and happily sells it for $100,000 at maturity plus interest calculated on the $100,000 lump sum instead of the cut down value $98,000.
Thus, the OID from the above example is $2,000.
Since interest is involved, there are welcome tax consequences. The original issue discount consequences do not encourage the transaction of bonds. In other words, the interest made at maturity is added to the bond’s price, converted to money, and added to the interest earned during the bond’s lifetime. These interests are considered taxable income and treated as an annual tax even if it is not yet mature.
The IRC states in Section 6049 that the OID transactions are taxable and should be filed with an annual tax report. Taxpayers that are brokers or other intermediaries should use form 1099-OID to report their OID taxes. With how strict it is, it is challenging to make deductions or manipulate taxes or interest. The IRS makes money out of the bond’s lifespan instead of the payment at maturity, making it difficult to remove a penny.
However, their rules only cover part of the bond system. Here are some exemptions.
United States Savings Bonds
Short-term maturity debt instruments either less than or equal to one year
OID municipal bonds
In addition, the IRC has a de minimis rule for bonds with discounts below 25 basis points less than the face value at redemption multiplied by the duration of the OID to maturity.
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